California law corporations face distinct tax obligations at the state and federal levels. These are typically structured as S-corporations or Limited Liability Partnerships (LLPs) in California.
Understanding the potential tax liabilities for different corporations is essential for compliance and for maximizing financial benefits. We work with shareholders in California law corporations and other professional corporations to ensure the best tax strategy and structure to protect shareholders from unnecessary liabilities.
State Tax Liabilities for Law Corporations Taxed as S-Corporations
In California, S-corporations enjoy pass-through taxation, where corporate income, losses, and deductions flow to shareholders, who report them on their personal returns. However, state-specific taxes create more unique challenges for a law corporation to account for.
The state imposes a 1.5% franchise tax on the corporation’s net income, with a minimum tax of $800, regardless of the corporation’s activity or profitability. This fee is required to maintain operations in California. For corporations reducing their taxes through special deductions, the alternative minimum tax (AMT) of 6.65% ensures a baseline payment.
S-corporations in California must also comply with passive income restrictions. Corporations with Subchapter C earnings and over 25% of gross income from passive sources like dividends or rents may face additional state tax liabilities. Additionally, employee-shareholders must receive reasonable compensation, or the state can reclassify income as wages, potentially increasing tax liability.
Federal Tax Liabilities for Law Corporations Taxed as S-Corporations
On the federal level, S-corporations avoid the double taxation applied to C-corporations. As mentioned above, income is passed through to shareholders and taxed on their individual returns, creating a single level of taxation.
However, federal rules do include additional considerations. Passive income taxes apply if passive income exceeds 25% of gross income and the corporation retains Subchapter C earnings.
Additionally, the built-in gains tax is triggered if assets are sold within five years of converting from a C-corporation to an S-corporation.
Employee-shareholders must also meet reasonable compensation requirements. The IRS expects wages to reflect the fair market value of services. If compensation is deemed insufficient, pass-through income can be reclassified as wages, resulting in higher tax liability.
Self-Employment Tax Liabilities
One of the most notable benefits of structuring as an S-corporation is the exemption from shareholder self-employment taxes. Unlike partners in an LLP or sole proprietors, shareholders of S-corporations do not pay self-employment tax on pass-through income. Instead, shareholders working for the corporation are paid wages, which are subject to standard employment taxes, including:
- FICA taxes: Covering Social Security (up to an annual wage cap) and Medicare (without a cap), split between the employer and employee.
- FUTA tax: Paid by the employer, applied to the first $7,000 of wages annually, supporting unemployment benefits.
While this structure reduces tax burdens, reasonable compensation rules still apply, and wages must accurately reflect the value of services provided.
A Refined and Thorough Tax Strategy for California Law Corporations
Taxation for California law corporations can be complicated, requiring the careful attention of an experienced attorney who understands the tax needs and tax strategy of California businesses. At Dahl Law Group, we help law firm owners understand their obligations and create tailored strategies to minimize liabilities while maintaining compliance. If you’re ready to refine your approach to taxes and strengthen the financial foundation of your practice, contact us at our offices in San Diego and Sacramento today.
Dahl Law Group
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